Definition
Passive management is an investing strategy that tracks a market-weighted index or portfolio. The most popular method is to mimic the performance of an externally specified index by buying an index fund. By tracking an index, an investment portfolio typically gets good diversification, low turnover, and low management fees. With low fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.
Passive Management
What is ‘Passive Management’
Passive management is a style of management associated with mutual and exchange-traded funds (ETF) where a fund’s portfolio mirrors a market index. Passive management is the opposite of active management in which a fund’s manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio’s securities. Passive management is also referred to as “passive strategy,” “passive investing” or ” index investing.”
Explaining ‘Passive Management’
Followers of passive management believe in the efficient market hypothesis. It states that at all times markets incorporate and reflect all information, rendering individual stock picking futile. As a result, the best investing strategy is to invest in index funds, which have historically outperformed the majority of actively managed funds.
The Research Behind Passive Management
In the 1960s, University of Chicago professor of economics, Eugene Fama, conducted extensive research on stock price patterns, which led to his development of the Efficient Market Hypothesis (EMH). The EMH maintains that market prices fully reflect all available information and expectations, so current stock prices are the best approximation of a company’s intrinsic value. Attempts to systematically identify and exploit stocks that are mispriced on the basis of information typically fail because stock price movements are largely random and are primarily driven by unforeseen events. Although mispricing can occur, there is no predictable pattern for their occurrence that results in consistent outperformance. The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance, which means active management strategies using stock selection and market timing cannot consistently add value enough to outperform passive management strategies.
Further Reading
- Passive investment strategies and efficient markets – onlinelibrary.wiley.com [PDF]
- Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk – www.cambridge.org [PDF]
- Asset management fees and the growth of finance – www.aeaweb.org [PDF]
- Active vs. passive management: New evidence from exchange traded funds – papers.ssrn.com [PDF]
- Steering capital: the growing private authority of index providers in the age of passive asset management – www.tandfonline.com [PDF]
- The shift from active to passive investing: potential risks to financial stability? – papers.ssrn.com [PDF]
- Economic implications of passive investing – link.springer.com [PDF]
- The value of management flexibility—a real option approach to investment evaluation – www.sciencedirect.com [PDF]
- Passive investors, not passive owners – www.sciencedirect.com [PDF]
